Is the Market for Oil Reinflating?

I have been amazed to watch the price of oil crash from its peak of $147 to its recent low of $62.  If you read my prior article, you know that I believed that there were strong fundamental reasons that were driving the price of oil higher. 

After oil prices collapsed 57% from their peak, the main reason given as an explanation for its fall was the decline of oil consumption as the economy began to slow.  While this theory certainly holds true to some degree, I believe the driving factor in oil's decline has been the lack of liquidity in the marketplace rather than the declining consumption of U.S. businesses and consumers.

In the last six months, there have two major events that have impacted petroleum pricing.  These two events were the bankruptcies of Semgroup (SGLP) and Lehman Brothers (LEHMQ.PK).  As you can see from my chart, Semgroup announced its bankruptcy on July 22, 2008.  This was only a week after oil prices peaked.  A few days before it declared bankruptcy Semgroup had a conference call with its creditors informing them of its problems. 

As knowledge of Semgroup's problems spread, anyone doing business with Semgroup took steps to cease any relationship with what was one of the nation's largest energy marketers and traders.  This counterparty risk created a bottleneck between energy producers and energy purchasers that prevented oil supply from reaching its end markets.

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On September 15, 2008, we had our second major event, the bankruptcy of Lehman Brothers.  This bankruptcy seemingly came out of nowhere because everybody had expected the Treasury to step in and broker a purchase of Lehman Brothers as it had done with Bear Stearns.  Instead, the Treasury balked and allowed one of the nation's largest investment banks to fail.  As a result, oil tanked the next day before rallying. 

Everything seemed fine for a couple of weeks as nobody could quite grasp the impact this would have on the US economy.  Then a couple weeks later the flow of credit stopped as fear of insolvency had crippled the ability of almost every financial institution to function normally.  Like all markets, the energy markets depend on credit to function, as most companies need credit to purchase oil inventories.  With the credit crunch in full swing, many players began to have problems obtaining financing.  This created yet another bottleneck in the nation's energy markets.

The ability of speculators and corporate entities to trade and own oil contracts was impacted by both of these events.  It is clear that if speculators are forced to liquidate long positions then oil prices are going to drop and the same can be said for corporate entities.  While the liquidity issue has become a major problem for the energy market, the counterparty risk issue has also developed.  With the Semgroup and Lehman Brothers bankruptcies, anyone owning contracts that Semgroup or Lehman Brothers were counterparties to was in trouble as they were more likely then not no longer safely hedged. 

The first round of capital injections in the US banking system, while saving our nation's banks will likely save the commodity market.  The bailout should eliminate the problems that are preventing the normal functions of the oil market, whose disruption was caused primarily by the bankruptcy of both Semgroup and Lehman Brothers.  So far, the behavior of the price of oil seems to be confirming this as the price of oil has rallied strongly from $63 on Monday.  Looking back, it is clear that the capital injection is also the most logical explanation for not only the rise of the stock market but the commodities as well. 

Disclosure: None

Comments

[mangolfer:]

The fall of oil was due to a worldwide drop in demand after the speculators put the screws to the consumer. Good luck trying to screw the consumer twice.

2008 Oct 31 07:56 AM

[john s. gordon:]

the parabolic rise of oil to 147 was pure speculation (tulip bulbs redux?) and not sustainable.

the opec producers have an incentive to keep oil price low enough so that alternatives/renewable... cannot gain traction in the marketplace. we had a lot of activity in conservation/solar/wha... during 1974-80 but it all went away in 1981.
> jack

2008 Oct 31 08:20 AM

[applesauce:]

The average worlwide cost of oil is about $ 65 for producers to breakeven.
New discoveries will not likely be funded in the short run and the supply will again tighten and prices will go up unless this recession last many years.
We need a new energy plan and instead of shelling out welfare checks we should spend on infrastructure and provide tax incentives for alt. energy so in ten years we are not under the cresent sword still.

2008 Oct 31 09:14 AM

[sikarskie:]

What were your fundamental reasons???????????????... they exist for 50-60 bbl.........no more..the rest is commodity run-up..Once we see the 20 to 1 leverage raised to 50% margin requirement on oil and gas contracts..it will limit the market manipulation of these UTILITIES.... and give stabilization to these sectors... currently 50000 manipulates 1,000,000.00 and that is why the drop occured ..no substance and when money was needed the contracts were sold ..oil dropped down to its support level of tangilbe pricing.
Lawrence

2008 Oct 31 10:04 AM

[dickus:]

When oil was at $147 per barrel, everyone denied that speculation was the cause. Now that is has dropped to half that price in a couple of months how can any sane person agrue that case. The worldwide demand for oil may have declined a bit in recent weeks, but not 50%. I am as sure as the author, that the price of oil will rise again as liquidity begins to flow back into energy.

2008 Oct 31 10:06 AM

[John Moss:]

I'm inclined to believe the rally you refer to was rather a movement based on pure fundamentals; The impending rate cut on the dollar, and the Friday report of a modest decrease in inventories. The inventory move was roughly 1 dollar upward, with the rest being a dollar for dollar match as the dollar crept downward.

2008 Oct 31 10:50 AM

[cjct:]

So you were completely wrong before and now we're supposed to believe anything you say. I think not!

2008 Oct 31 11:39 AM

[fakir:]

Lets be clear here , I have heard so many people now say that investment will not take place if the oil price falls too low and further down the line there will be a spike, pure humbug. A rational actor with deep pockets (most oil companies) will invest through this cyclical phase to profit from the price rise when it comes due to demand driven shortage or natural attrition.
Most project take at least 3 years to come online so the most important factor is what the demand and price will be then. The current front month contract has more to do with the here and now which says that there is more suply than demand and so prices must fall.

2008 Oct 31 05:38 PM

[sr9web:]

To: london callin

Many marginal projects are money losers under $65 bbl. If price goes too low for too long, producers hedge contract run out and the marginal projects must be mothballed or TONS of $$ is lost. If that happens, supply will drop and OPEC will be able to raise prices again.

2008 Oct 31 11:14 PM

[OctoberFaith:]

Rofl.

you don't get it, eg/ie/eg, gold = oil = money = all of them, fund managers just got shorted left and right. then got to feel guilty for it too.

Lol I get what you were trying to do. but no, I mean no but yes, but no. rofl

anyways can I come to class to now.

2008 Nov 01 07:01 AM

[OctoberFaith:]

Ignore my previous posts everythings fine. ty. control processes reset.

2008 Nov 01 07:17 AM

[derryl:]

The world's transportation system is powered by oil from which gasoline for cars, diesel for trucks, bunker fuel for ships and jet fuel for planes are made.

Without transportation the regional, national and global economies that supply us with our necessities of life, not just luxuries but necessities like food, is shut down.

Until some alternative to oil-fueled internal combustion power for our transportation system is invented, developed and implemented on an industrial/global scale we are hostage to oil supplies.

Before the recent financial troubles-cum-economic slowdown oil supply and oil demand were almost even at about 85 million barrels per day. At the peak there was only a few hundred thousand barrels of slack in the supply/demand equation.

Refiners were realistically worried they would not be able to buy oil regardless of the price because world demand was threatening to outstrip world supply. An oil "shortage" caused by economic fundamentals, not financial manipulations, was a real possibility.

New oil is getting harder to find and produce. It doesn't matter how profitable it might be to produce new oil, if you can't find it or can't get to it you can't produce and sell it. This is the "peak oil" scenario.

The easy oil that is readily accessible and cheap to produce has already been pumped (except for the Middle East, which still has lots of easy oil). We're into oil that is structurally more expensive to produce.

We can't not produce and use it as long as our transportation sector, without which we are literally dead, is utterly dependent on oil.

Financial troubles are arithmetic problems. We can fix them by seeing clearly and using our intelligence.

Economic shortages like peak oil are physical problems. Intelligence cannot fix a problem that cannot be fixed by finding new supplies that don't exist, or that are so hard to get at that we physically cannot do it.

We need an alternative to oil. But in the meantime our lives depend on our ability to buy enough of the stuff to keep our economy moving.

The "real" price of oil is the cost of producing the next barrel. Right now this is probably in the $65-80 range. $145 was a panic price, fear of supply shortage. Anything below $65-80 is not sustainable.

Anything over $100 is not sustainable either, because over $100 means way too big a share of our economic effort must be devoted just to moving ourselves around.

We cannot afford oil over $100. We see demand destruction at that price, which means people simply cannot afford to pay $80 to fill up their car so they take the bus instead even if that adds an hour a day to their commute time. I don't like the idea of spending my future standing at the bus stop.

Trucking costs rise so the price of everything that is transported, which in our economy is literally "everything", rise along with these structural costs.

Even if we invent the next form of energy to power our transportation system it will take 10-20 years at minimum to rebuild the infrastructure and get the new system in place.

So it looks like oil has to be over $65-80. And once the arithmetic problems of finance are solved and economies start moving ahead again we're back to tight supplies and oil price volatility until we solve our oil dependence problem.

2008 Nov 01 11:34 AM